How to get brokers / sellers to understand working capital?
October 24, 2019
by a searcher from Massachusetts Institute of Technology - MIT Sloan School of Management in Salt Lake City, UT, USA
One big hurdle I continually run into is brokers and / or sellers that don't understand working capital, primarily the fact that the valuation on the business assumes ongoing working capital in the business. Most sellers I've been communicating with think that they should be able to take all of the AR (and assume the AP) since "they did the work". Which, I'd be okay with in exchange for a commensurate reduction in company valuation, since I'd have to fund the new working capital with additional cash. But, they want the 4-5x EBITDA valuation plus take the working capital, which can be the equivalent of 1-2x EBITDA in some cases.
Part of the problem is that there are many brokers who don't understand this point either, and advertise the deals as "cash-free, debt-free, and receivables-free".
Any tips or ideas on how to get people to understand this point?
from Wake Forest University in Winston-Salem, NC, USA
There is no question that a buyer needs working capital on day 1. It turns out that only a minority of transactions in the <$50 million size include working capital in the purchase. The IBBA/M&A Source posts quarterly data that show the % of transactions that include working capital vs. exclude it. In summary, for deal sizes in the $500k-$1M range only 30% included working capital, $1-$2M only 36%, $2-$5M only 41%, and in the $5-$50M only 46% included working capital.. In the cases where it is not part of the purchase, it is usually provided by the acquisition lender in the form of a permanent working capital loan and possibly also a line of credit (this is usually right on their term sheet next to the acquisition loan).
In terms of valuation and pricing, the requirement is to be consistent with the data construction of the database of comparables and price accordingly as to whether it is the base price or the combined price (base plus working capital). For example, PeerComps explicitly excludes working capital in its Enterprise Value (it does include normal inventory, FF&E, and goodwill). Thus, the value derived using the PeerComps multiple is the base value, excluding NWC. If one was interested in the combined price (base + WC), as some buyers are, they would simply add the NWC to the base price to get the combined price. On the other hand, if you are using Deal Stats (fka Pratt’s stats), it sometimes does and sometimes does not include NWC. Deal Stats requires you to look at the detailed record of each transaction to determine if it does or does not. For a transaction that did include NWC, Deal Stat’s enterprise value would be higher than the same transaction in PeerComps by the NWC, and thus the multiple would also be correspondingly higher. Going in the opposite direction, BizComps explicitly excludes even inventory (it only includes FF&E and goodwill). So, when using that database, you multiple the SDE or EBITDA by the multiple, and then have to add the inventory value to get to the base price (including inventory).
As ^redacted rightly points out, whether or not the asking (or offered) price includes or excludes net working capital (i.e., is it a base price, or base + NWC), how they arrived at that decision, and what the working capital needs of the company are, should be clearly laid out in the confidential memorandum, and also documented in the LOI and purchase agreement. Definitely not something that you want to wait until close to closing to negotiate.
from City University of New York (CUNY) System in Tinton Falls, NJ, USA
The issue is that almost 100% of Main Street seller and brokers don't understand or care about WC as it relates to purchase consideration. They (sellers) are not educated that selling a business assumes appropriate WC - much like a an adult needs 2000 calories a day to survive, Take away the food and they will either lose a lot of weight and/or die.
You are correct, the Sellers see that the fruits of THEIR labor should be kept by them. They unfortunately never acknowledge that the cash they generate is not really theirs - it's the company's, and it needs it to survive like the adult human that needs the 2000 calories. Most brokers don't push that education on the sellers hard enough, and then tend to give a valuation commensurate without a WC peg, and then try to get over the disparity during DD ... hopefully and usually unsuccessfully..
Mid-market intermediaries tend to be more accustomed to this need and explain it more often to their clients up front. I'm not going to say the Seller accepts the fact of a WC peg and more than main street seller, but they come around quicker because the sheer volume of the numbers they live with each day to run a business is more pressing. In our firm, if the Seller doesn't understand what WC needs are, that it WILL be part of the deal, and that it DOES impact purchase consideration, we walk away before we even sign an engagement agreement.
In the end, it is and will always be a battle. Suggest you ask the broker or intermediary have they had a serious discussion with their client UP FRONT. Find out where the seller's mind is at before you even meet them, and even possibly have a third-party article in your portfolio that you can hand out to a seller when you meet them if they are unaware, uncomfortable, or unwilling to consider how WC impacts purchase consideration. It will either help your cause, or assist in getting off the bus more quickly!